ESOP vs. ESPP: What’s the Difference? 

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TLDR

• Generally, both ESOPs (or employee stock ownership plans) and ESPPs (or employee stock purchase plans) are employee benefit plans sponsored by employers to benefit their employees. Not only do these types of plans help employees create wealth, but they also promote ownership in your startup.
• According to the National Center for Employee Ownership (NCEO), ESOPs are the most popular form of employee ownership in the U.S., with 6,500 companies having an ESOP, thus allowing 14 million U.S. employees to participate in an ESOP.
• An ESOP is a qualified defined contribution plan governed by the Internal Revenue Code (IRC) and the Department of Labor (DOL). These plans are stock bonus plans explicitly designed to invest in qualifying employer securities, such as your startup’s stock.
• In an ESOP, an employer-sponsored benefit plan is set up with a trust, similar to other retirement plans like a 401(k). However, unlike a 401(k), tax-deductible contributions are solely invested in company stock. The law permits ESOPs to hold 100 percent of your startup’s stock or any percentage less than 100 percent. 
• Eligible employees who participate in the ESOP are called participants, and they accrue shares of company stock over time. Once a participant leaves the company, the company buys back the shares, giving the participants cash for the value of the shares. At that time, the employee is then taxed on the value of the stock.
• An ESPP is an employee stock purchase plan. These plans can be qualified or non-qualified by the IRS. Unlike ESOPs, ESPPs do not fall under the purview of the DOL. ESPPs are only available for publicly-traded companies, where employees can contribute part of their monthly compensation towards purchasing their employers’ stock at a discounted rate at specific intervals.
• RSUs are “unsecured, unfunded promises to pay cash or stock in the future and are considered nonqualified deferred compensation,” subject to the Internal Revenue Code. 
• Typically, one RSU represents one stock share. These stock units are generally not taxable when granted; however, they are taxed once the restricted stock units vest. Vesting is a process where the employees become entitled to the granted stock over a period of time, such as three years.
• Upon vesting, RSUs are assigned a fair market value. The Internal Revenue Service considers RSUs fully taxable upon vesting. After a portion of the stock shares is withheld to pay taxes, the employee receives the balance of the shares and may sell them at their discretion. 

Founders have several options for granting ownership in their startups. However, when you start digging into the options, it seems more like alphabet soup than compensation and ownership structures. 

Generally, both ESOPs (or employee stock ownership plans) and ESPPs (or employee stock purchase plans) are employee benefit plans sponsored by employers to benefit their employees. 

Not only do these types of plans help employees create wealth, but they also promote ownership in your startup. Employees with an ownership stake in your company are often more engaged willingly to promote your startup’s culture and values. This alone bodes well for your attraction and retention of top talent along with the overall success of your startup.

Despite the similar purposes, ESOPs and ESPPs are different types of employee benefits. In this article, we’ll break down the differences between ESOPs and ESPPs, as well as their benefits.

What is an ESOP?

An ESOP is a qualified defined contribution plan governed by the Internal Revenue Code (IRC) and the Department of Labor (DOL). These plans are stock bonus plans explicitly designed to invest in qualifying employer securities, such as your startup’s stock.

According to the National Center for Employee Ownership (NCEO), ESOPs are the most popular form of employee ownership in the U.S., with 6,500 companies having an ESOP, thus allowing 14 million U.S. employees to participate in an ESOP.

In an ESOP, an employer-sponsored benefit plan is set up with a trust, similar to other retirement plans like a 401(k). However, unlike a 401(k), tax-deductible contributions are solely invested in company stock. The law permits ESOPs to hold 100 percent of your startup’s stock or any percentage less than 100 percent. 

Eligible employees who participate in the ESOP are called participants, and they accrue shares of company stock over time. Once a participant leaves the company, the company buys back the shares, giving the participants cash for the value of the shares. At that time, the employee is then taxed on the value of the stock.

Since ESOPs are part of employees’ compensation packages, these defined contribution plans can help keep employees motivated and loyal – as ownership often helps employees focus on the startup’s performance. And rightly so. The better the company performs, the higher the value of the stock. And the employees directly benefit.

ESOPs and Corporate Transactions

In addition to granting employee ownership, ESOPs can also be used when founders are ready to sell their business. For example, an ESOP “can buy a departing owner’s shares in pre-tax dollars on terms that are highly favorable to the owner, the employees, and the business itself. Selling owners can sell any portion of their stock to the ESOP, and they can defer tax on the gain from the sale if certain requirements are met.” 

By using ESOPs in corporate transactions, such as those providing an exit strategy for the founder, the ESOP provides liquidity to the founder and favorable tax consequences for the founder. The departing founder can choose to sell all or some of their shares, providing for leadership succession, continuity of the startup’s culture, and a diverse wealth strategy for the founder.

The Tax Benefits of an ESOP

ESOPs enjoy favorable tax treatment. Here are some key benefits for both the startup and its employees:

• Tax-Deductible Contributions. Employer contributions of stock and cash are tax-deductible when they’re made. While this helps the founder’s cash flow, it also dilutes the current ownership of employees if new shares are issued. For cash contributions, this deduction is available whether the founder decides to use the cash to buy shares of startup stock for participants or to create a cash reserve within the ESOP.
• Tax-Deductible Loan Contributions. ESOPs can borrow money to purchase new or existing shares of stock. The employer still receives a tax deduction for the contributions to the plan, regardless of their source. This means that “ESOP financing is done with pre-tax dollars.” 
• Tax-Deductible Dividends. For any reasonable dividends used to repay a loan against the ESOP, passed through to participants, or reinvested by participants into startup stock, those dividends are also deductible.
• Tax-Favorability for Employees: ESOP participants don’t pay taxes on contributions to the plan. They are only taxed when they take a distribution from the plan. When participants take a distribution, they can roll over their ESOP assets to another qualified retirement plan or an individual retirement account (IRA). If they choose to take a cash distribution, the participants will pay regular tax rates on the allotment but capital gains on any earnings. However, if distributions are made early, such as before the normal retirement age, the participant will face an additional 10 percent penalty on the amount distributed.
• Tax-Deferral for Sellers of a C-Corporation Startup. For c-corporations, “once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.” 
• No Tax on Ownership for S-Corporations. In s-corporations, “the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well): That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.”

What is an ESPP?

So, now that we know what an ESOP is, what is an ESPP plan? An ESPP is an employee stock purchase plan. These plans can be qualified or non-qualified by the IRS. Unlike ESOPs, ESPPs do not fall under the purview of the DOL.

ESPPs are only available for publicly-traded companies, where employees can contribute part of their monthly compensation towards purchasing their employers’ stock at a discounted rate at specific intervals.

When an ESPP is qualified, “employees are not taxed on the discount at the time when they buy stock. Instead, they later pay capital gains on the profits realized when they sell their shares.” In non-qualified ESPPs, “the difference between employee stock price and fair market value at purchase is taxed as ordinary income.”

Shareholders who already own at least five percent of startup stock are not permitted to participate in the ESPP. 

ESOP vs. ESPP vs. RSU: What’s the Difference?

Adding to the alphabet soup of stock plans are RSUs, or restricted stock units. RSUs are “unsecured, unfunded promises to pay cash or stock in the future and are considered nonqualified deferred compensation,” subject to the Internal Revenue Code. 

Typically, one RSU represents one stock share. These stock units are generally not taxable when granted; however, they are taxed once the restricted stock units vest. Vesting is a process where the employees become entitled to the granted stock over a period of time, such as three years.

Upon vesting, RSUs are assigned a fair market value. The Internal Revenue Service considers RSUs fully taxable upon vesting. After a portion of the stock shares is withheld to pay taxes, the employee receives the balance of the shares and may sell them at their own discretion. 

Regardless of the differences between ESOPs, ESPPs, and RSUs, offering stock ownership to your employees is highly beneficial to both your team and your startup. With actual employee ownership, you can create a culture of dedicated, happy, productive employees, all directly contributing to the success of your startup.

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